The case for investing in this part of US stock market

Olivia Micklem, co-manager of Artemis US Smaller Companies fund, is the latest fund manager to appear in our Insider Interview series. Micklem explains the key attributes she's seeking when investing in US stocks with market caps below $10 billion, outlines sectors she's focusing on, and runs through recent portfolio activity.

She also makes the case for active fund management in this part of the US stock market as opposed to owning the market through an index fund or exchange-traded fund (ETF).

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to our latest Insider Interview. Today in the studio, I have with me Olivia Micklem, co-fund manager of the Artemis US Smaller Companies fund. Olivia, thank you for your time today.

Olivia Micklem, co-manager of Artemis US Smaller Companies: Thanks for having me.

Kyle Caldwell: So, Olivia, you invest in US smaller companies. Could you explain the investment process and your investment approach? Are there certain qualities or characteristics that you're looking for?

Olivia Micklem: Of course. So, we're looking in a universe of US smaller companies. For us, that's typically businesses with a market cap of below $10 billion (£7.7 billion). And what we're really trying to find are those businesses that can create a strong competitive mode, have a really strong competitive advantage, but also a really strong profitability profile, and an opportunity to maybe expand their margins and grow their cash flows over time, and use that to reinvest in the business or return that cash to shareholders and grow over time.

In addition, what we're also really trying to find are opportunities where we think the stocks are being mispriced, where we think there's an opportunity that there's more upside embedded in the stock and less downside risk. So, it's really that asymmetry that we're trying to identify and hopefully [we can] find those businesses and build a portfolio with those.

Kyle Caldwell: Smaller companies tend to make most of their money in their home market. So, which types of sectors are you focusing on within the US economy?

Olivia Micklem: We're trying first of all to look across all the sectors. We have a strong analyst team that's looking in specific sectors to find as many good ideas as we can. But, in general, we're also looking at what current macroeconomic trends might be, what some of the structural drivers are of the economy that we can try and benefit from.

At the moment, that includes areas like businesses that are benefiting from the capex spend for AI for data-centre builds. So, in smaller companies, that can be businesses that are perhaps involved in the construction of the data centres, those involved in powering the data centres, or any of the supply chain related to that build out.

Alongside that, we're also seeing opportunities in general infrastructure spending, things like roads and bridges programmes, and those kinds of programmes that were put in place under the Biden administration.

So, those are some of the current structural drivers that we're looking at. But alongside that, in smaller companies, we're always just trying to find interesting idiosyncratic businesses, whether they might be a growth opportunity, a particular product cycle, or something within a sector that we think might be interesting.

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Kyle Caldwell: You have a lot of companies to choose from. How many holdings does the fund typically have? And what's your typical holding period?

Olivia Micklem: So, the guidelines for the fund are for between 40 and 60 positions, but typically we're looking in the 50, mid-50s, 55 to 60 range at any given point in time. And that's really driven by what the ideas are that we're finding. In terms of the holding period, we don't specifically target a specific holding period. It's more important for us that we're able to realise all the value and the opportunity in the stock. That might take a year or two years to realise or longer or shorter, depending.

Kyle Caldwell: And in terms of style, as you're investing in smaller companies, would you say [it's a] more growth-focused portfolio?

Olivia Micklem: We would say that we're style agnostic. We're not deliberately trying to find just growth companies or just value companies. Really, for us, it's about the quality of the businesses. As I sort of alluded to with the profitability and the cash flow structure, what it leads us to have is a collection of businesses that tend to have a higher return on equity than the overall market. And for us, it's really that quality bias that I think is the most important part of the portfolio.

Kyle Caldwell: I wanted to next ask about portfolio activity. How often do you make changes to the fund and could you name some of your most recent purchases?

Olivia Micklem: So, we're always actively managing the fund. We're always looking at where we might find opportunities to add to positions, or time to sell out of a position. In addition, the team of analysts, we're always looking for new ideas that we think might be interesting.

In terms of some of the positions that we've added over the last few months, one is a retail stock called Boot Barn Holdings Inc (NYSE:BOOT). They make cowboy hats and cowboy boots and sell to other markets like that. They've had really strong success with the concept in certain markets and now are they able to grow that store footprint over the US. So, that's a nice growth opportunity.

Alongside that, we've also bought a business called First Industrial Realty Trust Inc (NYSE:FR). It's a real estate investment trust, and we see some really nice growth opportunities there as well. So, two very different parts of the market, both interesting opportunities.

Kyle Caldwell: Now for investors who are looking for US smaller company exposure, an option they have is to simply own the market through an index fund or an exchange-traded fund, an ETF. Could you make the case for active fund management as investors, of course, could buy a product that tracks the Russell 2000 index or the S&P 600 index?

Olivia Micklem: Our view would be that particularly in something like the Russell 2000, there are an awful lot of businesses that aren't making any money and in some cases may not even generate any revenue. So, at this point in time, that number has got to about 40% of the Russell that are unprofitable businesses.

In our view, in order to be able to succeed as a business over the long term in the US market, you need to have that profitability profile to really be able to fund your business over time. So, we would argue that if you're buying the index, you're buying exposure to that 40% that may never survive. They may end up going out of business, or just never really getting past the point of making any actual money.

We would argue that what you want is an active manager who can really go after the businesses in that profitable pool that really can succeed and establish themselves within their sector in the US economy.

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Kyle Caldwell: Over the very long term, smaller companies typically outperform larger companies across various markets, including the US. What are the main reasons behind that trend, and do you think that the trend has legs in the future?

Olivia Micklem: I think in the US market, in particular, what you have are these businesses that have the opportunity to really grow. The US offers a huge economy for them to grow into, huge opportunities, whatever sector you might operate in. And so I think that tends to deliver some of these outsize returns that you see over the very, very long term.

What's been challenging more recently, certainly, is that that outperformance hasn't really been coming through. We've seen the stronger growth really coming from the larger-cap end of the market, particularly driven by the tech sector. I think over time we would expect that to broaden out and you can start to see the smaller company part of the market really start to accelerate, particularly given a backdrop of relatively healthy economic growth, and the opportunity for that part of the market to really accelerate again.

Kyle Caldwell: Olivia, thank you for your time today.

Olivia Micklem: Thank you for having me.

Kyle Caldwell: So, that's it for our latest Insider Interview. Hope you've enjoyed it. You can let us know what you think. You can comment. And for more videos in the series, do hit that subscribe button. And I'll hopefully see you again.